The Report the SEC Doesn't Want You to See

New details in a report on the collapse of Bear Stearns released by the Office of the Inspector General overseeing the Securities and Exchange Commission shows how dangerously lax the SEC's oversight of Wall Street really was.

It also gives damaging evidence that the SEC's hands-off approach helped cause the credit bubble to dangerously inflate.

Specifically, the Inspector General's report, which is based on internal SEC memos, shows that the SEC did little to stop a debt load that has decimated Wall Street and caused an historic market crisis that is remaking the entire U.S. financial system.   

The Inspector General's report, now on Sen. Charles Grassley's Web site, provides fresh detail on the SEC's laidback oversight of Wall Street. It comes as the government has enacted a massive $700 bn bailout plan.

More than three times that sum is being pumped into the markets by the Federal Reserve, as Wall Street's disastrous foray into subprime derivatives has caused the profits earned during the bubble, as well its capital, to go up in a puff of smoke.

"The SEC Inspector General found that officials responsible for monitoring the safety and soundness of our nation's largest investment banks ignored red flags and risky behavior," Sen. Chuck Grassley said in a statement. "Those institutions are now gone or re-organized and our financial system is in crisis. As [SEC] Chairman Christopher Cox said himself, the program was an utter failure."

The Republican Iowa senator has already asked a top government watchdog to find out why the Enforcement Division of the Securities and Exchange Commission declined to bring a case last year against Bear Stearns for improperly valuing mortgage-related investments (see June blog "Did the SEC Miss Warning Signs at Bear Stearns?")

The SEC has said that it applied the appropriate international standards for holding-company capital adequacy in a conservative manner, but that, despite its best efforts, Bear could not withstand a run on the bank.

To avoid broad market panic and disarray, the Fed stepped in last March to orchestrate an eleventh hour merger between JPMorgan Chase (JPM) and Bear Stearns, with the Fed agreeing to take onto its books $29 bn in bad assets from Bear Stearns in order to get JPMorgan to agree to the deal.

The March 14 takeover of Wall Street's smallest yet one of its most recklessly run firms was a bellwether event in the credit meltdown.

What Exactly Happened at Bear Stearns

The Inspector General's report lays out what exactly happened at Bear Stearns prior to its implosion.

At the time, Bear Stearns, which ran one of the country's largest clearing operations, was the Street's biggest player in the mortgage-backed bond market. By the time of its collapse, it had taken on too much water by keeping on its books hundreds of billions of dollars in mortgage bonds backed by subprime assets.

However, the report shows how the SEC did nothing to get Bear Stearns to pare back its business in this area and to boost its capital cushion, as Bear steadily leveraged itself up to a terrifying 33 to one capital ratio--meaning, for every $1 of assets, it was swamped with $33 in debt (the figures do not include off-balance sheet debt.)

The problems uncovered by the SEC's Office of the Inspector General were reported by Bloomberg, which noted that the SEC initially issued a censored report. Grassley's office has put up an uncensored version of the report on its website.

This story provides fresh detail.

The SEC had allegedly removed a section of the publicly distributed report showing that its Division of Trading and Markets, which oversaw Wall Street, knew Bear Stearns's capital ratio had dropped to 11.5% in March from as high as 21.4% in April 2006.

Ten percent is the minimum standard under international banking regulations. Capital ratios measure the amount of cushion a firm has as a percentage of its risk-weighted assets.

Bear's History in Mortgage-backed Bonds

Bear Stearns had a long history of dealing in mortgage-backed securities on Wall Street. In 1997, Bear Stearns did the first securitization of loans from the Community Reinvestment Act, a 1977 law that caused an increase of 80% in the number of bank loans given to low- and moderate-income families.

Bear's first securitization of CRA loans was a $384 mn offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 bn of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 bn in CRA loans with $20 bn going to securitized mortgages.

SEC Under Fire

The SEC is now being criticized, not just for its ad hoc, costly after-the-fact refereeing.

More broadly, the agency is under fire for doing little to stop the enormous, imprudent and indefensible leverage that investment banks under its purview took on during the housing and credit bubble, with much of that debt shoved in off-balance-sheet vehicles. And regulators did little to stop the explosion of derivatives that has decimated Wall Street.

It's clear Wall Street did not have an overseer as the SEC left investment banks to their own devices, turning the free market into a free-for-all.

Former SEC Official Talks

And the SEC has only itself to blame, former SEC official Lee Pickard tells the New York Sun's Julie Satow. 

Specifically, the SEC relaxed the agency's net capital rules that initially limited their debt to net capital ratios to 12 to 1 in 2004.

The move was a concession made in which the firms let the SEC conduct more oversight of Wall Street firms operating as both a broker dealer and a holding company, something the SEC, called in a jargon-loaded phrase, its new "Consolidated Supervised Entity Program."

The SEC's program ``was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily,'' SEC chairman Christopher Cox said on Sept. 26 in announcing the  program's shutdown.

Pickard says the SEC subsequently let five investment firms-Bear Stearns, Lehman Bros., Merrill Lynch, Morgan Stanley and Goldman Sachs-more than double the leverage on their balance sheets, blowing out their debt to net capital ratios to unheard of levels, for instance, at Merrill Lynch to 40 to 1.

As Jill Schlesinger, president of Strategic Point Advisers, has said: "A fence at the top of a cliff is better than an ambulance at the bottom."

But at the SEC, that fence was potted with holes.

Focus on the Letter, Not the Spirit, of the Rules

As noted, Bear Stearns had a gross leverage ratio of 33 to one at the time of its collapse. Again, that meant that essentially for every dollar it had in assets, it borrowed $33. 

But according to the SEC, Bear Stearns had a high of $21 bn in liquidity in early March 2008, at the time of its near-death experience, versus $7.6 bn in May 2007. To agency officials, that seemed to suffice.

However, the Inspector General says that even though Bear was compliant with the SEC's capital requirements, the firm's collapse raises serious questions about the adequacy of the agency's capital ratio requirements to begin with.

The Inspector says the more pertinent and serious question though is "whether Bear Stearns had enough capital to sustain its business model."

It clearly didn't.

Problems Found

In fact, at the outset of the SEC's oversight of the new capital reserve regime beginning in 2004, Bear Stearns was allowed to operate with a smaller capital cushion because it was, well, smaller.

Although Bear had more capital than $5 bn, the Inspector General's report indicates it was treated more leniently due to its smaller size.

The Inspector General's report says that according to agreements between the SEC "and the United Kingdom's Financial Services Authority entered into April 2006," each firm was "required to maintain a liquidity portfolio of cash or highly liquid debt and equity securities of $10 bn, with the exception of Bear Stearns which was required to maintain a liquidity portfolio of $5 bn."

The SEC consults with the UK in its oversight of the markets, notably to make sure that the firms are in compliance with international capital standards, known as the Basel accords.

Bear's perilous capital reserve problem was made more dangerous given the chaos in Bear's risk management.

Bear's Bad Risk Management

The Inspector General found that the SEC became aware of numerous potential red flags prior to Bear Stearns' collapse

An unedited version of the 137-page study on Sen. Grassley's web site reveals that during the bubble, right when disaster was about to strike, Bear Stearns' traders had virtually zero management of the risk they were engaging in.

All of Wall Street uses value at risk models, a modeling technique deployed to gauge the probability of portfolio losses based on statistical analysis of historical price trends and volatilities.

But the Inspector General found that Bear Stearns did not periodically evaluate its VAR (value at risk) models, nor did it timely update inputs to its VAR models.

Moreover, the Inspector General found that Bear Stearns used outdated models that were more than ten years old to value mortgage derivatives and had limited documentation on how the models worked.

Outdated Indeed

The Inspector General found that Bear Stearns' "stress scenarios included the 1987 stock market crash, the 1998 collapse of Long Term Capital Management and the 9/11 terrorist attacks because these crisis scenarios resulted in the greatest potential losses."

However the Inspector General found that SEC "internal memoranda provide no discussion of the most serious forward looking risk scenario that Bear Stearns might face, which was a complete meltdown of mortgage market liquidity accompanied by fundamental deterioration in the mortgages themselves, resulting from falling house prices."

The report says that the SEC's discussions with Bear's risk managers in 2005 and 2006 "indicated that Bear Stearns pricing models for mortgage securities focused heavily on prepayment risks" but the SEC's "internal memoranda rarely mentioned how Bear's pricing "models dealt with default risks."

Bear's risk managers also did not have much experience with mortgage-securities, the Inspector General alleges. "Given the risk managers' lack of expertise in mortgages, it would have been difficult for risk managers at Bear Stearns to advocate a bigger focus on default risk in its mortgage models," the report says.

The reported added that "it was only toward the end of 2007 that Bear Stearns incorporated measures to reflect house price appreciation or depreciations into its mortgage models."

SEC Aware Bear's Top Risk Manager Quit

Bear lost its top risk modeler ``precisely when the subprime crisis was beginning to hit'' and writedowns were being taken, the report says. ``As a result, mortgage modeling by risk managers floundered for many months," the report charges, quoting internal SEC memos from April and December 2007.

Because of the chaos, Bear's "mortgage modeling by risk managers floundered for many months," the report says. According to the Inspector General, "this disarray in [Bear's] risk management tended to give trading desks more power over risk managers."

And get this: The Inspector General says the SEC "was aware that the model review function was typically understaffed at Bear Stearns for much of 2007."

SEC Aware, Did Little

It gets worse.

The Inspector General found that the SEC became aware of numerous potential red flags prior to Bear Stearns' collapse "regarding its concentration of mortgage-backed securities and lack of compliance with... certain Basel II standards, but did not take actions to limit these risk factors."

The Inspector General notes that internal SEC memos say Bear Stearns actually pushed to increase "balance sheet and risk-taking authority, despite the fact that it had already won six limit increases since 2001."

The Inspector General's report says that the SEC even found that the amount of mortgage securities was occasionally well beyond even Bear Stearns' internal limits.

Specifically, the report says the SEC knew that "risk management of mortgages" and mortgage assets at Bear Stearns "had numerous shortcomings, including lack of expertise by risk managers in mortgage-backed securities at various times" and "lack of timely formal review of the mortgage models" that Bear used to price its securities.

Zero Foresight, Maximum Pain

Surprisingly, the Inspector General found that there was "no documentation of discussions between [the SEC's] division of trading and markets and Bear Stearns of scenarios involving a meltdown of mortgage market liquidity."

Also the report says that the SEC "did not require Bear Stearns to reduce its exposure to subprime loans."

In fact, Bear Stearns model review process "lacked coverage of mortgage-backed and other asset-backed securities, in part because the models were not used for pricing and in part because the sensitivities to various risks implied by the models did not reflect risk sensitivities consistent with price fluctuations in the market" the report says.

And check this out. The Inspector General says that Bear Stearns risk managers did not rely heavily on the firm's risk models to price and hedge various derivatives, deferring to traders instead, the report says.

The Inspector General goes on to say that Bear's "traders used their own models...for hedging purposes and not the ones that the risk managers were reviewing."

Conflicts Abounded

The report says that: "In fact, model validation personnel, modelers and traders all sat together at the same desk, engendering ‘potential disadvantage of reducing the independence of the risk management function from the trader function," the report says.

Bear Stearns is Cavalier

As Bear Stearns was submerging itself with toxic mortgage bonds and other bad assets, it should have become clear to the SEC that the firm was dangerously undercapitalized, the Inspector General's report says.

Two weeks before it collapsed, the SEC asked Bear about raising more capital, the report says. Specifically, the report says that SEC memos suggest that in March 2008, regulators "inquired about whether Bear Stearns was contemplating capital infusions, but the memo does not suggest that" the SEC "exerted influence over Bear Stearns to raise additional capital.

But a footnote to the report reveals that while the SEC did talk to Bear Stearns chief executive Alan Schwartz about what the firm was doing, Schwartz said there were no "terribly current discussion, that they had hired Lazard [Freres] to advise them but that was on ‘slow burn' and that with the time it would take to get that done (a capital raise), it wouldn't help" as "rumors would cause more damage" in the meantime.

The SEC let it go at that, the report says, because it felt the firm was adhering to international standards on adequate capital, called the Basel banking accords.

"In this sense," the report says, the SEC "acted as though it did not believe it had a mandate to compel Bear Stearns to raise additional capital as long as its Basel capital ratio was greater than 10%."

In fact, Bear Stearns did not raise additional capital in 2007 or 2008. 

Bear Stearns' Cut and Paste Jobs 

It's clear now that many of these mortgage-backed securities were not as liquid or tradable as a share in, say, IBM or a barrel of oil is.

Instead, investors must depend on the Wall Street firms that create and sell them to get an inkling of what they are worth, valuations the firms can cook up on their own, according to accounting rules. It doesn't help the credit rating agencies mindlessly gave these bonds triple-A ratings-debt securities built on the backs of shoddy subprime loans which suddenly transmogrified into gold-plated securities.

But check out this interview in the August 2005 edition of Wall Street & Technology with Ralph Cioffi, one of the former Bear Stearns hedge fund managers now under arrest. In it Cioffi reveals how rickety the whole process of creating credit derivatives really is.

The interview notes that Cioffi explained that in the dealer-to-customer market, traders mostly construct contracts for certain derivatives over the phone and via Bloomberg e-mails.

Transaction and settlement records are created through a good deal of cutting and pasting of documents, and confirmations sometimes do not arrive for as long as 90 days, he noted.

Question: Did Cioffi, or anyone else on Wall Street for that matter, vet the underlying collateral backing these securities, the mortgage debt taken out by shaky borrowers? Answer: No.

 "When we execute via Bloomberg," Cioffi continued in the interview, "we have to notify our back office through an e-mail, we calculate the settlement amount, the dealer sends us the amount and then we notify the buyer or seller of protection, so there are a number of steps."

Really? Did any of those steps include checking in on homeowners who got loans with no money down and no assets?